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Cyprus 'Bailout Taboo Explained 

Stfan Hofrichter 

5 Questions with Stefan Hofrichter 


Stefan Hofrichter, chief economist at Allianz Global Investors, discusses the latest chapter in the euro-zone debt crisis, including precedent-setting rescue measures, why tiny Cyprus matters in a global context and what it means for the markets.

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Key Takeaways

Cypriot parliament rejected the EU support package due to strong opposition to the proposed bank-deposit haircut
A taboo has been broken: Cyprus crisis marks the first time a proposed bailout called for a direct payment from citizens
If a deposit levy isn’t approved, then one alternative for Cyprus would be to sell gas exploration rights to a third party such as Russia, but the value of these rights are unclear. Look for Russia’s influence in Cyprus to increase
We are confident that the European Central Bank (ECB) will not pull the plug on the Cypriot banking system in the next few days. We can’t rule out contagion in the euro-zone periphery, but the treatment of depositors in Cyprus is not a blueprint for other markets
Expect more uncertainty in the short-term. However, the implications for capital markets should be rather contained

What happened in Cyprus?

Cyprus is the latest country in the euro zone to have financial issues necessitating a bailout. Its fiscal crisis has escalated in the wake of the parliament’s rejection of a €10 billion bailout from the International Monetary Fund (IMF) and European Union (EU), which included a €5.8 billion levy on Cypriot bank accounts. A taboo was broken: It marked the first time a proposed bailout required a direct payment from citizens. Unless lawmakers can come up with a new solution or the rescue package is revised, Cyprus’ banks could lose access to the cheap credit that kept their economy afloat for months. Without low-cost loans from the ECB—Emergency Liquidity Assistance (ELA)—Cyprus risks a collapse of its banking system and a potential exit from the euro zone. Meanwhile, bank branches in Cyprus have been closed for several days to prevent a bank run.

Here are key tenets of the rejected proposal:

  • €10 billion bailout package
  • An agreement on fiscal austerity that includes higher corporate taxes and capital income taxes
  • Privatization of state-owned companies and the introduction of a money-laundering audit
  • Taxes on savings deposits in the private sector: Deposits of up to €100,000 will have to pay a 6.75% tax on deposits; the tax rises to 9.9% for deposits greater than €100,000
  • Junior bondholders would take a hit; senior bondholders wouldn’t

Why were small depositors being “bailed in?”

There was no agreement reached to provide more than €10 billion of bailout money. Hence, Cyprus had to finance the remaining €7 billion of funds, perceived to be necessary to stabilize the banking system on its own. The reason why the European Monetary Union (EMU) did not want to provide more funds to Cyprus are, amongst others, that the Cypriot banking system at 800% of GDP is perceived to be excessive and is perceived to be involved in money laundering, particularly Russian money.

Still, it is unclear why small depositors were actually asked to contribute. Ideally, the hit on deposits more than €100,000 could have been higher, while deposits less than €100,000 are not touched at all. Since the Single Supervisory Mechanism (SSM) is not yet in place, European Stability Mechanism (ESM) money cannot yet be directly channeled to Cyprus’ banking system.

What are the potential market consequences?

We can’t rule out a contagion effect on other EMU periphery countries: depositors in Ireland, Portugal, Spain, Italy and Greece may anticipate that deposits under €100,000 are not safe and will start a bank run. The deposit run that came to a halt in late 2012 may resume. This may happen even though the EMU has pointed out that Cyprus is a “special case” because of the inflated size of its banking system and its likely involvement in money laundering. The problem: it’s the second special case in the EMU—the first one was Greece. Will there be a third one?

What’s next for Cyprus?

If the deposit haircut doesn’t happen, then Cyprus has to raise €5.8 billion in a different way. If the debt sustainability calculations are followed, then a simple credit rollover from Russia or any other third party is not possible. One way out for Cyprus would be to sell gas exploration rights to a third party such as Russia, but the value of these rights are unclear. Cypriot finance minister Michael Sarris is in Moscow trying to secure aid from Russia.

Ahead of Wednesday’s ECB council meeting, there are rumors circulating that capital controls are being considered in case Cypriot banks re-open soon. Over the medium-term, Russian influence in Cyprus will rise. EU influence will decrease. The situation will stay unclear for the moment, but we are confident that the ECB will not pull the plug on the Cypriot banking system in the next few days. Cyprus has refused the bail in of depositors. We expect Cyprus to come up with €6 billion otherwise it would forfeit the €10 billion Troika rescue.

What’s your outlook?

Market uncertainty is likely to increase until a new deal is struck. While the risk is clear, the longer-term implications for markets will be much less severe than what followed Greece’s private-sector involvement. So far, the market reaction to the parliamentary vote has been very calm in both equities and fixed income. Here’s why: Cyprus is indeed a special situation. The treatment of depositors in Cyprus is not a blueprint for other markets because of the size and quality of its banking system. Most recently, reports from the Troika—the European Commission (EC), the IMF, and the ECB—have been quite constructive on Portugal, even though the country is expected to miss its deficit targets.

The ECB threatened to pull the plug on the Cyprus banking system if the bailout wasn’t approved. One could argue that the ECB sent out two signals: a) the banking system in Cyprus is not relevant for the EMU financial system b) the ECB is ready to use outright monetary transactions (OMT) if necessary. Cyprus’ economy is very small in size, around 0.2% of EMU GDP. The market reaction in EMU periphery bonds as well as in equity markets confirms our view that, ultimately, the implications for capital markets should be rather contained.

Still, Cyprus’ treatment of small depositors comes at a time when news about the solution of the EMU debt crisis have deteriorated again. (Troika leaving Greece without accord; Italy’s election outcome.) Our analysis shows that market volatility is likely to rise in 2013. Will the Cyprus deal be the ultimate trigger?
The material contains the current opinions of the author, which are subject to change without notice. Statements concerning financial market trends are based on current market conditions, which will fluctuate. References to specific securities and issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Forecasts and estimates have certain inherent limitations, and are not intended to be relied upon as advice or interpreted as a recommendation.

Gross domestic product (GDP) is the value of all final goods and services produced in a specific country. It is the broadest measure of economic activity and the principal indicator of economic performance.

Allianz Global Investors Distributors LLC, 1633 Broadway, New York NY, 10019-7585,, 1-800-926-4456.


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